Analysts Prove Hazardous as Contrarian Stocks Surge

Consumer shares such as Netflix Inc., the Los Gatos, California-based movie service that posted the biggest gain on the S&P 500, rising 219 percent, led the advance. Photographer: Jin Lee/Bloomberg

Jan. 10 (Bloomberg) -- Following the advice of equity
analysts may be perilous for your profits.

Companies in the Standard & Poor’s 500 Index that analysts
loved the most rose 73 percent on average since the benchmark
for U.S. equity started to recover in March 2009, while those
with the fewest “buy” recommendations gained 165 percent,
according to data compiled by Bloomberg. Now, banks’ favorites
include retailers and restaurant chains, the industry that did
best in last year’s rally and that are more expensive than the
S&P 500 compared with their estimated 2011 profits.

Investors who look at the analysts as a contrary indicator
are buying shares of utilities, which pay the highest dividends
after telephone stocks, and banks, whose earnings are likely to
grow three times as fast as the S&P 500 this year. Don Wordell,
a fund manager at Atlanta-based RidgeWorth Capital Management
Inc., says equities that Wall Street firms rate lowest are more
likely to beat the market.

“When you have a stock that has 15 analysts covering it
and it has 15 buys, I can’t imagine it has much outperformance
left,” said Wordell, whose $1.64 billion RidgeWorth Mid-Cap
Value Equity Fund topped 98 percent of peers in the past five
years. “You’ve got a stock that has 15 sells on it, you’re set
up there to have some strong outperformance.”

Netflix, Cummins

The benchmark index for American stocks rallied 13 percent
in 2010. Consumer shares such as Netflix Inc., the Los Gatos,
California-based movie service that posted the biggest gain on
the S&P 500, rising 219 percent, led the advance, along with
industrial companies like Cummins Inc., the Columbus, Indiana-based engine maker that advanced 140 percent.

Analysts said health-care and technology companies would
win in 2010. Instead, they had two of the three smallest rallies
among 10 industries in the S&P 500, gaining less than 10
percent. The stocks analysts liked least, banks and real estate
firms, rose 19 percent and 28 percent, respectively, in 2010.

S&P 500 companies with the most “buy” ratings gained 8.7
percent in 2010, while the ones with the fewest jumped 20
percent, the data show. Bloomberg assigns each analyst rating a
number ranging from 1 for “sell” to 5 for “buy.” For this
article, stocks with at least five ratings on Dec. 31 were
divided into three groups by average rating. Only rankings from
analysts who still cover the companies were counted.

Stimulus Spending

The Federal Reserve’s unprecedented stimulus, including a
program to buy $600 billion in bonds, to lower unemployment and
boost growth spurred stocks whose earnings are most tied to the
economy, such as Cleveland-based iron producer Cliffs Natural
Resources Inc., which gained 69 percent. Earnings for S&P 500
companies rose 32 percent in 2010, analysts estimate, the
fastest growth since 1994.

“You scratch your head and wonder, ‘Which part of this am
I missing that the market is getting right?’” Butler said. His
picks generated a 13 percent return in the past year, beating
the average 8.9 percent gain from analysts following the
industry, according to data compiled by Bloomberg.

Health-Care Miss

Analysts recommended health-care stocks on speculation the
government would fail to pass legislation overhauling the
industry, according to Butler. U.S. President Barack Obama
signed his health-care policy into law on March 23, imposing
fees on drugmakers and mandating insurance coverage.

Banks have been among the lowest-rated stocks in the S&P
500 even as they gained 172 percent since the rally began in
March 2009. Sixteen lenders in the index may report average
earnings growth of 44 percent in the 2011 as business recovers
from the worst financial crisis since the Great Depression,
forecasts compiled by Bloomberg show.

An improving economy and fewer write-offs for bad loans led
to a surge in regional bank stocks last year, said Kevin St.
Pierre, an analyst at Sanford C. Bernstein & Co. He recommended
shares of Zions Bancorporation, a Salt Lake City-based lender
that jumped 89 percent in 2010. The company started last year as
the eighth lowest-rated stock in the S&P 500.

‘Easy and Safe’

“Throughout most of ‘09 and early 2010, it was very easy
and safe to be negative on the financials,” said St. Pierre in
an interview from New York. “Many analysts in different sectors
said, ‘I’m not going to catch these falling knives.’ Knives were
falling all over the place at the end of ‘09.”

Following St. Pierre’s recommendations in the past year
would have generated a return of 17 percent, exceeding the 1
percent average increase from analysts following the industry,
data compiled by Bloomberg show.

Analysts couldn’t foresee that changes to financial
regulations would threaten profits at larger lenders, driving
investors to smaller ones, said David A. George, a bank analyst
at Robert W. Baird & Co. in St. Louis.

“A year ago today, financial regulatory reform was not
even on people’s radar,” said George, ranked fourth by returns
among 34 analysts who cover Wells Fargo & Co., according to data
compiled by Bloomberg. “Going into 2010, a lot of investors
were positioned in big banks. With the increased political and
regulatory scrutiny, you saw money come out of those names and
into the regionals.”

Missing Gains

At the end of 2009, George had “neutral” ratings on
Zions, KeyCorp, SunTrust Banks Inc., M&T Bank Corp. and Marshall
& Ilsley Corp. Each gained at least 26 percent in 2010.

Analysts are also bearish in 2011 on S&P 500 utilities,
which offer a collective dividend yield of 4.32 percent,
according to data compiled by Bloomberg. That’s more than twice
the 1.86 percent yield of the S&P 500. Only telephone companies,
at 5.17 percent, pay more.

Merchant generators, which sell power in wholesale markets,
will be hurt by falling natural-gas prices, while traditional
regulated utilities are expensive relative to forecast profit,
said Michael S. Worms, a New York-based utilities analyst at
Bank of Montreal. Southern Co., the largest U.S. electricity
producer by market value, trades for 16 times estimated 2011
earnings, compared with 13.4 for the S&P 500.

‘Almost Fairly Valued’

“The bottom line is gas prices are down, and they will
hurt the merchants,” said Worms, who has a “market perform”
rating on 25 of the 29 companies he covers. “On the regulated
side, I guess you can say they are almost fairly valued.”

Priceline.com Inc. and Darden Restaurants Inc. are among
the S&P 500 companies analysts favor most, helping give so-called consumer discretionary stocks the second-highest average
rating among 10 industries in the index behind health care. The
stocks rallied as the economy gained momentum and U.S. retailers
reported higher-than-estimated sales in November.

The measure of 79 stocks including hotel operators and
restaurant owners rallied 26 percent last year, exceeding gains
from the index’s nine other main industries. The group now is
valued at 1.1 times sales, the highest since 2000, according to
data compiled by Bloomberg.

“Our main reason for optimism is that the economy has
gained its footing and spending is picking up on the corporate
side,” said Matt Arnold, an analyst at Edward Jones & Co. in
Des Peres, Missouri, who has 10 “buy” ratings and 6 “holds”
on consumer companies. “That could yield some improvement on
the employment front and in consumer spending, which will find
its way down to retailers.”

Unemployment Rate

Spending is unlikely to bounce back enough to help the
stocks given that the unemployment rate is within 0.7 percentage
points of the 26-year high set in October 2009, said Paul
Lejuez, a New York-based analyst at Nomura Holdings Inc. U.S.
payrolls increased 103,000 in December, compared with the median
forecast of 150,000 in a Bloomberg News survey, Labor Department
figures showed Jan. 7. The jobless rate fell to 9.4 percent,
partly reflecting a shrinking workforce.

“With unemployment where it is, we are not out of the
woods here,” said Lejuez, who has 11 “neutral” or “reduce”
ratings out of 18 stocks and downgraded Gap Inc. to “neutral”
from “buy” on Jan. 7. “There’s too much complacency out there
in terms of people assuming everything is great.”

Priceline, the second-largest online travel agency, trades
at 46 times reported profit, the most expensive level since
2004. The Norwalk, Connecticut-based company gained 83 percent
last year. Analysts’ estimates show Orlando-based Darden, owner
of the Olive Garden restaurant chain, will increase profit
excluding some items by 13 percent this year, compared with the
S&P 500’s projected growth of 14 percent.

“The problem with stocks that are loved by everyone is
that there’s no one left to buy them,” said Paul Zemsky, the
New York-based head of asset allocation for ING Investment
Management, which oversees $550 billion. “It’s hard to make
money if you’re in the consensus.”